Why were voices of reason on risk ignored in the US?

Published in The Australian Financial Review

Many myths are circulating about the root cause of the crisis in financial markets created by Wall Street. The root cause was none of securitization, the housing price collapse, predatory lending, free markets, short selling, innovation or borrowing short lending long. Not even greed, regulation or lack of it was the direct cause. Sound risk management can cope with all these simultaneously.

Risk management relies on accurate measurement of risk. If the risk is not measured and seen it cannot be managed. The root cause of this crisis was announced in 1996 in a report published in Euromoney’s Corporate Finance. The report exposed a devastating flaw in a risk measurement method called VaR (Value at Risk) imposed on the financial markets by Wall Street. I was the report’s author. It warned that widespread reliance on VaR left the financial markets exposed to a risk Tunguska, as I called it. Named after a massive aerial explosion 8km above Eastern Siberia on June 30, 1908 which devastated 500,000 acres. My point was to emphasis the seriousness of the problem, now exploded closer to home in 2008. I published many other papers in the 90s on the same theme including the book Risk Mechanics, finding and fixing risk holes.

VaR hides the many complexities of market risk. In particular, it ignores elements of risk associated with catastrophic loss. Yet, in the 1990s, Wall Street “rocket scientists” aggressively marketed VaR establishing it as the accepted standard of market risk measurement.

Imagine a fruit and veg trader from main street attempting to value a concealed bag of fruit and veg by its weight only. He has no idea if the bag contains potatoes, a mixed bag or bad apples. The single statistic of weight alone does not enable the fruit and veg trader to price the bag or understand the risk of holding it. Yet VaR is every bit as naive as the fruit and veg trader attempting to value his investment on weight alone. Less is not always more.

A long term solution to this crisis must answer why so many investment banker “rocket scientists” embraced a risk measurement method as naive as VaR. Why were voices of reason ignored? Whatever the motive, the rise of VaR made it easy to sell financial instruments with catastrophic elements in their payoffs. Promoters of these instruments are rewarded on a time scale much shorter than the expected time scale of these catastrophes.

Senior managers and regulators felt relaxed and comfortable with a risk measurement process with a name like “Value at Risk”. As the volume of financial instruments with hidden but massive risk holes ballooned the day of reckoning in the financial markets, the risk Tunguska, was inevitable.

Published version - AFR - 6 Oct 2008

Tags: global financial crisis, market risk, risk management, risk measurement, Risk Mechanics, Sub-prime market, Value at Risk, VAR, Wall Street